By Lesley Wroughton

WASHINGTON (Reuters) - The International Monetary Fund on Saturday urged donors to meet their aid pledges to the Palestinian Authority, warning that unless funding was forthcoming it would be forced to cut public wages and social benefits to address a deepening fiscal crisis.

The IMF said the aid-dependent Palestinian economy had entered a "difficult phase" with a severe liquidity crunch worsening since last year due to a drop in aid from Western backers and wealthy Gulf states and Israeli restrictions on trade.

An IMF report released on Saturday, prepared for a donor meeting on Palestinian aid in Brussels next week, estimated a financing gap of about $500 million. The Palestinian authority is relying on donor aid to cover its 2012 budget deficit projected to reach $1.1 billion.

Most Palestinian aid comes from the United States, the European Union and Arab nations, allowing the Palestinian Authority to pay the salaries of public workers and benefits.

But the United States, which is trying to restart Israeli-Palestinian peace talks, cut off funding last year when Palestinian President Mahmoud Abbas defied calls from Washington and made a unilateral bid for statehood recognition at the United Nations.

Palestinian officials say more than $150 million of U.S. aid is frozen.

The IMF said just $800 million of $1 billion in promised budget support was disbursed in 2011. In addition, development aid was only $169 million compared with $370 million committed by donors.

IMF mission chief to the West Bank and Gaza, Oussama Kanaan, said it would be very difficult for the Palestinian Authority to cover the 2012 financing gap without donors making good on existing pledges and providing additional aid.

He said steady declines in foreign assistance had led to a large increase in domestic payment arrears of about $500 million to private businesses, and increased government debt to commercial banks to around $1.1 billion.

CANNOT TAKE ON MORE DEBT

"The stock of indebtedness has increased to such an extent that the PA is no longer able to postpone payments to the private sector and to banks," Kanaan said. "If money from the donors isn't forthcoming ... the only way it can cut expenditures is to cut wages or social benefits."

"The deficit is very large and it cannot compensate anymore for the shortfall by accumulating debt because the private sector will not allow them and banks will not lend them much more," he added.

The IMF said the Palestinian Authority should immediately prepare a contingency plan to cover the financing gap given the uncertainty of international aid flows. It should start cutting expenditures, increasing tax revenue and ensuring that the wage bill, which represents more than half of total expenditures, is contained.

"This will prevent a situation where the PA is forced by continued aid shortfalls to take drastic measures at short notice, such as a sudden curtailment of social transfers or payment of only a portion of the wage bill," the report said.

The IMF said while the size of the wage bill had declined in recent years, at about 18 percent it was still significantly higher than the 10-15 percent typically found in countries of similar stature.

The IMF warned that growth could slow further in the Israeli-occupied West Bank if the fiscal situation worsened and aid levels continued to decline.

Real GDP growth in the West Bank eased to 5.7 percent in 2011, compared to annual averages of 9 percent in 2008-2010, while unemployment was unchanged at 17 percent, it said.

"There is a high risk that growth will dampen further due to fiscal retrenchment, declining aid and consequent severe liquidity difficulties, the global economic slowdown, as well as the lack of easing of restrictions on movement and access since 2011 due to government of Israel's security concerns," the IMF said.

In the Gaza Strip, a smaller territory controlled by Hamas Islamists, growth surged about 20 percent last year after restrictions on consumer goods were eased and internationally supervised development projects increased.

Still, the IMF said, continued controls on private investment and exports would likely slow growth in the Gaza Strip and unemployment would remain at around 30 percent.

(Editing by Mohammad Zargham)




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